An Alternative Way to Play a Smackdown

There are a number of ways of playing a crash in share prices. The traditional methods investors use would be to buy out of the money puts by the truckload hoping they get the timing right on a big move. If they got the timing right, they won big. If not, they lose all the premium paid for the options. Those that wanted to spend less to make a bundle would buy an out of the money put spread. By selling a downside put, one can reduce the premium paid. But in so doing, they give up the big gain of a crash. In addition, if the price does not fall, the investor would still lose all the premium paid for the position.

As part of our research efforts, we look for techniques that take advantage of big moves without requiring large cash commitments up front and avoid significant capital loss, should the market go against the thesis. These techniques typically entail creating a synthetic call or put. One of the techniques we use here at The Options Edge is a short Call Spread Risk Reversal (sell a call spread, buy a put). This is essentially a synthetic put. Properly structured the investor will lose a very small amount or break even if the price of the underlying does not change or even rises. The short Put Spread Risk Reversal is a synthetic call that can have similar characteristics. While these structures are neither common or uncommon, they combine options in a very predictable way to take advantage of a large move.

One way we learn is to observe what others are doing. We noticed another trade taking place in the institutional market that has intrigued us. Since it provides an alternative to traditional methods of hedging and speculating, we think it is important for our readers to be aware of it. It entails the use of VIX options and the following is a detailed discussion of the technique.

Implied volatility as measured by the VIX Index has an inverse relationship with the performance of the S&P 500. When share prices rise, the VIX falls and when share prices fall, the VIX rises. There are of course limits to this relationship. The VIX Index rarely trades below 10% and when it does, it usually does not stay there long. Even if share prices relentlessly rise, the VIX may dip below 10%, but it quickly rises above 10% on the smallest of sell-off and sometimes even when share prices simply move sideways. The chart below shows a regression line between the Returns on SPY (S&P 500 ETF) versus the Rate of Change on the VIX Index. Notice the strong inverse relationship between the two.


This inverse relationship creates an opportunity to hedge returns delivered by the S&P 500 with a volatility derivative (i.e. VIX Futures, Options or ETFs). To do so, all one has to do is buy a VIX Futures contract or a call on VIX or buy an ETF/ETN like VXX (iPath S&P 500 VIX ST Futures ETN). It is important to remember that the VIX is far more volatile than the returns generated by the S&P 500. So one only needs to commit a small amount of capital to a VIX derivative to get the hedge you are looking to achieve. This makes the VIX contracts attractive vehicles for some institutional investors and speculators. Let say, you wanted to hedge a 2% daily move in the S&P 500. All you would have to do is commit $78,000 notional in VIX Futures for every $1,000,000 million of exposure to the S&P 500 you wanted to hedge. One can use options on VIX as well, for double leverage.

We think the speculative trade we see in the market from time to time seeks to take advantage of the leverage embedded in the VIX Index. The implied volatility on 1-month, at-the-money options is currently about 10%. The volatility of VIX is about 9 times higher at 93%. As a result, the VIX call options have a high level of time premium and will suffer rapid time decay. The speculative trades we see use options as a way to package risk more, but they need to be used wisely or time decay can eat you alive. In the trade we see taking place on the VIX options market, it appears the trader seeks a balance between performance and time decay. To manage the cost of the speculative trade, the institutional investor uses a modification to the call-spread risk-reversal structure. In a call spread risk reversal, the investor buys a call spread and offsets some of the cost by selling a put. The following summarizes the structure of the trades we see cross the tape. (We have adjusted the prices to current levels to make the analysis more intuitive and relevant.)

Looking at this structure more closely, the investor sells a near the money put to generate some cash to pay for the ratio call spread. This is where trading VIX futures are a bit tricky. The relevant underlying price to determine if the option is in or out of the money is not the spot price of VIX. It is the forward price reflected in the Futures market, which is currently around 13.45%. Another way to think about this is that the 2.5-month volatility is 13.45%. So in an unchanged market (one that simply matches market expectations), we would experience a 13.45% volatility and the contract would expire at the 13.45% level. When the trade is initiated, the trader will collect $53 per structure. If the VIX settles between 12% and 15%, the investor keeps the $53. If on the other hand, the forward VIX rolls to spot VIX, which remains at the 10% level, the contract would close out at 10% causing the investor to lose $1.47. (12.00-10.00+0.53) per structure.

Profit/Loss Analysis

The chart above shows how this trade will perform at it ages given various levels of VIX. The blue line shows the performance of this trade given an instantaneous change in the spot price of VIX. Notice that if the trader gets the collapse in equity prices he is looking for, he does not profit from the trade. As VIX increases, the gains on the short $12 strike put and the long $15 strike call are overwhelmed by the loss on the 2, $25 strike calls sold short when the VIX hits the 18% level. The trade needs to age while the VIX remains elevated to a capture profit. This trade will be most profitable if the VIX spikes in December. You can see this by observing the red line. The best this trade can do is generate $10.52 in profits. This will occur if the VIX trades at 25% at expiration.

We can see why this institutional investor would put on this trade, but we do not think this is a good way to go about speculating on or hedging against a crash. On the plus side, the investor is probably risking no more than $1.50 to $2.00 to make $10.50, so there is a lot of leverage and potential in the trade. But this is an expensive insurance policy. If we stay in a low volatility environment for another year and the investor rolls over the trade, they will suffer this $1.50 to $2.00 loss, over and over again. If it happens enough time, they may never have a chance to earn back their losses. The chart below shows that pops in VIX happen quite regularly. So there is a good chance this trader will experience the volatility spike they anticipate.

But, as we stated above, if the spike comes early in the trade, the investor will lose money, not make it. This is a grave traders sin. Get the move right, but lose money on the trade. So it is critical to get the timing right and that means the spike needs to come close to options expiration. The third challenge with this trade is speed and liquidity. If you get the spike and the trade does show a nice profit, you have to trade quickly and take what the market will give you as the spikes in volatility may last just a day or two. This is not much time to finesse a trade. This is not an insignificant issue for this trader as they have done this trade 263,000 times.

In the final analysis, it’s hard to see a scenario at this time that would convince us that this is the best way to position one’s portfolio for a sharp selloff. If we wanted to take such a stance, we would focus on a long put-spread or short call-spread risk-reversal or possibly a long-dated near the money put on the S&P 500. We think there will come a time when hedging your portfolio and/or speculating on a sharp selloff will be appropriate, but that day has not come yet.




I am long a diagonal call spread (long a long-dated out of the money call, short a near-dated closer to at the money call) on VXX.